Reserve Demand, Interest Rate Control, and Quantitative Tightening

Abstract

We provide a framework for understanding banks’ demand for central bank reserves. The main reserve demand drivers are: The spread between market rates and the interest rate on reserves, banks’ liquidity needs (implying that reserves generate a convenience yield), and bank balance sheet costs. Given reserve demand, we show how central banks control equilibrium short rates via interest on reserves, reserve supply and lending/borrowing facilities. We estimate reserve demand for the US from 2009M1-2022M10 and use the estimated reserve demand function to (a) guide the setting of interest on reserves, and (b) assess how much quantitative tightening is feasible.